MONETARY OPERATIONS DEPARTMENT Belgrade, 29 December Q & As ABOUT THE DECISION ON FINANCIAL DERIVATIVE TRANSACTIONS

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1 MONETARY OPERATIONS DEPARTMENT Belgrade, 29 December 2011 Q & As ABOUT THE DECISION ON FINANCIAL DERIVATIVE TRANSACTIONS ( RS Official Gazette, No 85/2011) 1. Question: Does the open foreign currency balance sheet position referred to in section 6, paragraph 1 of the Decision on Financial Derivative Transactions (hereinafter: the Decision) include also foreigncurrency clause indexed dinar claims/liabilities? Answer: Pursuant to regulations governing bank's open foreign currency balance sheet position and foreign exchange risk indicator, open foreign currency balance sheet position includes also foreign currency clause-indexed dinar claims/liabilities. 2. Question: Can residents freely perform financial derivative transactions? Answer: Residents may freely perform transactions in financial derivatives that are traded in a regulated market or multilateral trading facility (MTF) abroad, pursuant to section 3, paragraphs 1 and 3 of the Decision. Please note that transactions in standardised financial derivatives in a regulated market and MTF may only be performed through a bank, in accordance with a regulation governing the terms and conditions and the manner of performing foreign payment transactions. Outside of the regulated market and MTF, residents may perform financial derivative transactions with non-residents and banks only for the purposes envisaged by the Decision and/or for the purpose of managing foreign currency and dinar inflows/outflows pursuant to section 3, paragraphs 2 and 3, and sections 4 and 6 of the Decision. 3. Question: How does one prove that the purpose of performing financial derivative transactions complies with the Decision, i.e. the existence of risks stipulated in section 3, paragraph 2 and section 4, paragraph 1, the existence of future foreign currency payments/collections, open foreign currency balance sheet position or managing foreign currency inflows/outflows (section 6 of the Decision)? Answer: To prove that the purpose of a financial derivative transaction complies with the Decision, in addition to submitting the financial derivative contract, a resident shall be required to make a statement to

2 the bank confirming that the purpose of the transaction complies with the Decision. It shall be assumed that the resident's bookkeeping records contain evidence of an underlying transaction related to the risk the resident hedges against and/or an open foreign currency position and/or a swap contract concluded for the purpose of managing foreign currency and dinar inflows/outflows, and the resident shall be deemed accountable accordingly. 4. Question: Are residents natural persons allowed to perform financial derivative transactions? Answer: The Decision also pertains to residents natural persons from Article 2, section (1) of the Law on Foreign Exchange Operations and such natural persons therefore may also effect payments, collections and transfers under financial derivatives trading, but only pursuant to the terms and conditions and in the manner stipulated by the Decision. 5. Question: Why trading in non-deliverable derivatives is not permitted by the Decision? Answer:The National Bank of Serbia has decided not to permit conclusion of non-deliverable derivative contracts in this phase of foreign exchange market development because of the potential risks they carry as has been already made manifest in foreign markets. With non-deliverable derivatives, transactors may contract high amounts without undertaking the obligation to settle at maturity, since only price differences need to be settled. Potential ease of taking these positions i.e. using high leverage entails the risk of speculation. 6. Question: Why the Decision does not specify hedging against credit risk as a legitimate purpose of financial derivative transactions and are credit default swaps (CDS) permitted? Answer: The Decision does not permit residents to enter into such derivative transactions (with a bank or non-resident) outside the regulated market and/or MTF. However, no such restriction is imposed by the Decision on banks (section 2) so they may contract such derivative transactions with another bank and non-resident. Note that, bearing in mind negative effects of CDS instruments on financial stability manifested in foreign markets, the National Bank of Serbia does not support the development of this market segment at this level of development of Serbia's financial market. 7. Question: What does a standardised master agreement on financial derivatives imply? Answer: Standardised master agreements on financial derivatives seek to regulate the performance of derivative transactions outside the regulated market, taking into account the international practice. Such agreements, guided by the generally accepted standards and principles, provide legal protection to both the bank and the client and facilitate their operations. Until a domestic standardised financial derivative 2

3 contract is designed, which is typically published by the national bankers' associations, a master agreement that banks normally conclude with their clients shall be considered a standard derivatives contract. 8. Question: What is the derivatives clause referred to in section 10, paragraph 2 of the Decision? Answer: The derivatives clause pertains only to credit and deposit operations including, for example, optional elements and does not pertain to credit or deposit operations with the standard currency clause or clause on variable interest rate (linking the terms of the transaction to movements of interest rates EURIBOR, LIBOR etc.). 9. Question:Does the reporting on transactions including the derivative clause form FINDER 3, relate to the contract value of the underlying transaction or to the current transaction balance? Answer: On FINDER 3 form banks report data on the contract value of credit and deposit transactions (excluding claims and liabilities in respect of interest and fees) as at the last day of the ten day period for all transactions contracted but not yet due, irrespective of the contract date. 10. Question: Does the Decision require reporting on executed covered currency forward transactions? Answer: Yes, data on concluded and/or executed covered currency forwards are also reported under the Decision. 11. Question: What is meant by netting referred to in section 8 of the Decision? Answer: Pursuant to international rules and standards governing financial derivatives, netting is a possibility of offsetting debts and claims between contracting parties under these transactions. Particularly important is close out netting. This type of netting assumes that in certain cases, as stipulated by a regulation and/or contract, claims and liabilities between the parties in respect of financial transactions which are not yet due may be offset upon the termination of the contract for example, in the event of a counterparty default or bankruptcy, when automatically or at request all individual contracts are terminated under general contract and net liabilities/claims are calculated. This clause is generally included in a regulation governing bankruptcy proceedings. 12. Question: What is meant by the regulated market and multilateral trading facility (MTF) and how do they differ from the OTC market? 3

4 Answer: These markets were defined with reference to the Law on the Capital Market ("RS Official Gazette, No 31/2011) which derives its definitions from the EU Directive 2004/39/EC. Pursuant to the Law on the Capital Market, regulated market and MTF are operated and/or managed by a market operator stock exchange and/or investment firm (broker-dealer company) licensed by the competent supervisory authority. Only licensed investment firms may trade in the regulated market (stock exchange) and MTF, while other persons may trade only through the intermediation of those firms. Generally, the competent supervisory authority keeps the register and publishes the list of all licensed market operators. The decision also prescribes that only transactions in standardised financial derivatives may be performed on the regulated market and MTF. Such derivatives are generally registered with the institution in charge of keeping the registry of securities and other financial instruments, while their trading, clearing and settlement is regulated by rules and regulations of the market operator. OTC market is not required to have a market operator and trading in such market assumes that transactions (contracts) are concluded through negotiation between the buyers and sellers of financial instruments. Pursuant to the Decision, outside of the stock exchange and/or MTF, residents may enter into financial derivative transactions only to hedge against certain types of risks, and/or manage foreign currency and dinar inflows/outflows through and/or with a bank, under the terms and conditions and in the manner set by the regulation. 13. Question: What are cross currency interest rate swaps CIRS? Answer:CIRS is a transaction which includes periodic exchange of interest payments (calculated on the contracted principal amount) over the agreed time period and the exchange of principal amounts (at the pre-agreed rate) at maturity. Interest payments are made in different currencies and are calculated based on interest rates agreed separately for each currency. 14. Question: What are exotic options? Answer: Exotic options differ from plain vanilla European or US options by a more complex payoff feature, i.e. their execution depends on the fulfilment of a certain set of conditions. 15. Question: What are amortizing, i.e. drawdown swaps, as a type of an interest rate swap? Answer: Amortizing, i.e. drawdown swaps are a type of an interest rate swap with a variable underlying. Amortizing swap is a swap whose underlying-principal is amortized during the life cycle of 4

5 this instrument. For example, this swap enables an investor holding an amortizing bond with the fixed interest rate, i.e. sinking funds option (e.g. Republic of Serbia s London Club debt bonds) to convert it into a variable interest rate bond. Drawdown swaps are swaps whose underlying-principal rises during the life cycle of the instrument. 16. Question: What is OIS (overnight index swap)? Answer: Overnight indexed swap (OIS) is a fixed-for-floating interest rate swap where floating rate is based on weighted average rate of overnight transactions. 5